We seem to be going into some kind of a refi period, be it just a minor short-lived period or a major boom. Some contend that it could be even bigger than many imagined because of the overhang from the last refi wave, which still had many borrowers with loans above 9% who did not refinance.
Many of those borrowers were shut out because of declines in property values in certain areas and credit constraints. However, property values in the Northeast have improved, and many strapped borrowers have improved their financial situation because of the strong economy in the past year.
This means the potential refi pool is larger than just those who obtained mortgages since the end of 1993. If so, then lenders, servicers, and mortgage-backed security holders should brace themselves for a rash of prepayments.
It is too late to lament that very few safeguards have been implemented to stem portfolio runoff. However, there are some things that can be done now and in the future.
If a lender is concerned about portfolio runoff, he might want to contact borrowers first to offer refinancing before they go elsewhere or someone else solicits them.
Adjustable-rate lenders may wish to devise an instrument with a lifetime feature that allows for converting to a fixed rate at any point after one year. This would eliminate the need for a borrower to make a decision before his conversion period expires. Since there is no expiration, he might hang on to it longer, figuring that there is no pressure to convert.
ARM lenders might also want to consider not offering deep discounts on initial rates to keep the loan from being underwater from day one. This would also help if the loan does convert before fully indexed.
The other feature that would alleviate prepayments would be prepayment penalties for three to five years in exchange for a slightly lower rate.
However, many borrowers do not like the idea of a penalty. So why not simply change the name and the concept? Instead, call it a "deferred refund fee" that is collected up-front and applied to the loan balance or rebated if the loan stays on the books for five years. Then there is an incentive to keep the loan at least until the fee is refunded. This sounds better than threatening the borrower with a penalty if the loan is prepaid early. Use a carrot rather than a stick.
Obviously, some inventive lenders would have to work out the details of such a concept and maybe even enhance it. They might even offer a slightly lower rate during the first five years, depending upon calculations of losses from newly originated or recently purchased servicing.
Another possible idea to avoid prepayments would be to offer a one-time downward rate adjustment during the life of the loan. There would be no charge for this feature. It would make them feel that they can get a no- point, no-cost refi whenever the spirit moves them. This keeps the lender/servicer from losing the loan.
By knowing they can lock in a lower rate, many may never use it; instead they would sit on the fence waiting for that bottom eighth, which may never arrive.
This one-time adjustment feature used in conjunction with the deferred refund fee might just be enough to keep the loan on the books.
The point is that the fickle borrower is in the catbird seat when rates start to fall. Something better needs to be invented to keep them happy.
For instance, a full-service financial institution may wish to offer a package of services along with a mortgage - free checking, higher yields on savings, reduced car loan rates, etc. - that would be an incentive to keep the loan with the lender. Once the loan prepays for other than a sale, the other goodies disappear. That may cause the borrower to rethink the advantage of refinancing for only a quarter of a point.
Mr. Holm is publisher of Holm Mortgage Finance Report, where this comment first appeared as part of a longer article.
